South of Border, a False Dilemma

A sense of great pessimism has fallen over Mexico. In the face of renewed financial turmoil and severe contagion from Russia, people are asking whether stability, sustained growth and prosperity will ever be achieved. With a rapidly depreciating peso and obscenely high interest rates, the future looks bleak and hopeless. Suddenly, the guarded optimism of a few months ago has given way to sorrow and frustration.

Tired of what seems to be a never-ending story of economic instability, Mexicans are increasingly willing to contemplate solutions that not long ago would have been considered extreme and politically unfeasible. Two lines of thought on how to address the current problems seem to be emerging.

On the one hand, some groups associated with the financial sector have argued that the only way to reduce instability is for Mexico to give up its currency and “dollarize” its economy. According to this view, most of Mexico’s economic ills stem from the country’s inability to maintain a stable currency. If the peso is abandoned in favor of the U.S. dollar, we are told, stability will be achieved.

Intellectuals associated with the left, on the other hand, have argued that Mexico’s problems are the result of excessive globalization. According to them, the solution lies on decoupling from the rest of the world. The North American Free Trade Agreement should be revised, controls on capital mobility should be imposed, import duties should be hiked and direct foreign investment should be accepted only selectively.

Both of these views represent an overreaction to the current situation and strongly miss the point. Most of Mexico’s current problems have domestic roots that can be traced back to three very specific political and financial factors. Neither dollarization nor decoupling would address these factors directly.

First and foremost, the country’s political future is extremely unstable. For the first time in Mexico’s modern history, the opposition has a real chance of capturing the presidency in 2000. Encouraged by this, opposition members of Congress have been unwilling to cooperate with the government in passing key legislation.

Second, in spite of the authorities’ hopes, the banking sector continues to face tremendous difficulties. The recent hike in interest rates has further weakened bank loan portfolios, increasing the proportion of nonperforming loans. The country’s archaic legal and judicial systems have not helped. Banks cannot make guarantees effective, nor can they seize property given as collateral. Under these circumstances banks are unable to lend, contributing to further contractions in liquidity, higher interest rates and creating a vicious circle.

Congress’ unwillingness to approve legislation that would normalize the operation of the federal loan-restructuring agency, the Banking Fund for the Protection of Savings, or Fobaproa, has complicated things further by increasing the degree of financial uncertainty.

Finally, Mexico is facing a serious fiscal problem. In order to finance programmed increases in social-sector expenditures, the government has proposed eliminating a number of exceptions to the value-added tax. However, the two main opposition parties that jointly control the lower house of Congress are unlikely to approve this legislation. This would leave the government facing a difficult decision: either push forward with the expenditure plans, increasing the fiscal imbalance, or cut funding for social projects.

But this is not Mexico’s only, nor even the more serious, fiscal problem. The uncertainty on the future of the banking system and the distinct probability that the government will have to bail out the banks once again has created huge contingent liabilities of the federal government. Aware of this problem and of its potential destabilizing effects, investors have become increasingly skittish and are demanding (once again) large premiums for maintaining their funds in Mexico.

If the governing and opposition parties are willing to give a little, things in fact could work. The opposition has to recognize that banks have to be recapitalized urgently, the government has to agree that some senior officials have to be made accountable for the banking debacle and the private sector has to accept that recapitalizing the banks will mean that current ownership will be strongly diluted.

Acting now would help the country to recapture strong growth at the same time as it follows its recent path toward democratization. Postponing action will only mean greater poverty, stagnation and political polarization.